{"id":2814,"date":"2025-09-10T16:55:42","date_gmt":"2025-09-10T16:55:42","guid":{"rendered":"https:\/\/gtmtax.com\/?post_type=insight&p=2814"},"modified":"2025-10-06T12:58:12","modified_gmt":"2025-10-06T12:58:12","slug":"partial-bad-debts-an-opportunity-hiding-in-plain-sight","status":"publish","type":"insight","link":"https:\/\/gtmtax.com\/insight\/partial-bad-debts-an-opportunity-hiding-in-plain-sight\/","title":{"rendered":"Partial Bad Debts: An Opportunity Hiding in Plain Sight"},"content":{"rendered":"
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*Originally published in the Fall 2025 edition of the PICPA’s Pennsylvania CPA Journal. View here<\/a>.\u00a0<\/em><\/p>\n

Bad debts can be an unfortunate circumstance for any type of business in any type of industry and in any type of economy. When a customer or debtor fails to pay a liability, the business may need to write o\ufb00 the unpaid amount as bad debt. However, it is not an \u201call or nothing\u201d proposition, as some bad debts may not be entirely worthless. In some cases, only a portion of the debt is considered uncollectible, while the remainder may still hold value as there is hope it can be collected in the future. These are referred to as partially worthless bad debts. Understanding how to properly manage partially worthless bad debts may o\ufb00er tax relief both in the character and timing of a deduction and minimize the overall loss for the business.<\/p>\n

Bad Debts in General <\/strong><\/h4>\n

Internal Revenue Code Section 166 provides for a deduction for bad debts that are both wholly worthless and partially worthless. There are, however, certain criteria that must be met for a taxpayer to claim a bad debt deduction. First, the taxpayer must establish that bona \ufb01de debt exists. A bona \ufb01de debt is debt that arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a \ufb01xed or determinable sum of money.1<\/sup> When determining if a bona \ufb01de debt exists, courts generally look at the intention of the debtor-creditor relationship; the existence of a written, executed agreement establishing the debt with de\ufb01ned terms and a maturity date; and whether there is a reasonable expectation of the debt being repaid, among other factors.<\/p>\n

The taxpayer holding the debt also needs to determine whether the debt is a business or nonbusiness debt. Very broadly, business debt is any debt that arises in connection with a taxpayer\u2019s trade or business, while a nonbusiness debt is everything else.2<\/sup> This is a key factor. A business bad debt generally results in an ordinary deduction, whereas nonbusiness bad debts would result in short-term capital loss treatment, which may not be overly helpful to the taxpayer. Furthermore, only business debts are eligible for a partially worthless bad debt deduction, while nonbusiness bad debts are only deductible when wholly worthless.<\/p>\n

To claim any bad debt deduction, a taxpayer must be able to demonstrate that the receivable or amount owed to them became worthless during the tax year, either in part or in whole, and that there is no reasonable expectation of recovery. The burden of proving worthlessness falls on the taxpayer and typically requires professional judgement by analyzing all the relevant facts and circumstances related to the debt.<\/p>\n

The subjective nature of this determination could invite scrutiny from the IRS, therefore obtaining and documenting the evidence supporting a conclusion that a debt is worthless is always advised. This can be supported by \ufb01nancial statements of the debtor, collection e\ufb00orts and correspondence, bankruptcy \ufb01lings, settlement agreements, change in decline in collateral, among other corroborating evidence. Also, taxpayers must attach a statement to their respective income tax returns in the year in which they are claiming a bad debt deduction that highlights the particular facts substantiating any deduction claimed under Section 166.<\/p>\n

Partially<\/strong> Worthless<\/strong> Bad<\/strong> Debt <\/strong><\/h4>\n

A partially worthless bad debt is pretty much exactly what it sounds like. It is when a creditor determines that only a portion of a debt has become uncollectible during the tax year. This may occur in a bankruptcy situation where the debtor is only able to repay a portion or certain percentage of its outstanding liabilities, but not all. Or, possibly, the debt was in dispute, and the creditor and debtor negotiated a settlement that is typically for an amount less than the original liability that the creditor believes they were owed. The ability to claim a partial bad debt deduction allows the creditor to claim a tax deduction related to the debt while it is still legally outstanding and before it becomes wholly worthless, which could be years later.<\/p>\n

To claim a partial bad debt deduction, the debt cannot be a \u201csecurity,\u201d otherwise the rules of Section 1653<\/sup> take precedence, which is beyond the scope of this article. A security related to indebtedness, as de\ufb01ned under Section 165(g)(2)(C), includes a bond, debenture, note or certi\ufb01- cate, or other evidence of indebtedness issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form. In addition, the taxpayer must charge o\ufb00 the debt on its books4<\/sup> in the tax year for which it is claiming the deduction.<\/p>\n

While the write-o\ufb00 may be recorded to the general reserve account for U.S. GAAP purposes, it must be directly related to the speci\ufb01c debt to be deductible for tax purposes. This prevents the taxpayer from claiming a deduction for an asset when it still holds value on its balance sheet under other standards, such as U.S. generally accepted accounting principles. This requirement may seem like another hurdle, but it can be advantageous to the taxpayer and allows for \ufb02exibility in deciding when to take the deduction to maximize its bene\ufb01t.<\/p>\n

It is important to note that such \ufb02exibility in the timing of the deduction does not exist once the debt becomes wholly worthless, as the deduction must be taken in the year it becomes wholly worthless or it may be lost. In addition, consideration must be given to whether this is viewed as a change in method of accounting for income tax purposes, which requires the \ufb01ling of Form 3115, Application for Change in Accounting Method.<\/p>\n

Generally, the amount of the deduction is equal to the taxpayer\u2019s adjusted basis in the debt \u2013 not its face value. For a taxpayer on the accrual method of accounting, this would generally be the face amount plus any original issue discount (OID) that has accrued while they held the debt and any accrued but unpaid interest on the debt. For a cash-basis taxpayer, the amount of the deduction would generally be the face amount plus any OID. If a debt held by a cash-basis taxpayer were a trade receivable, there would be no bad debt deduction since they did not previously report any income on the receivable and therefore have no cost basis in the debt.<\/p>\n

While claiming a bad debt deduction typically would not involve an actual exchange of assets, caution should be given when a taxpayer receives a partial payment in the retirement of the debt instrument. This could invoke other implications, such as Section 1271 exchange treatment, which may lead to capital loss characterization if the debt instrument is a capital asset in the hands of the taxpayer.<\/p>\n

Conclusion<\/strong><\/h4>\n

Bad debts will always be a part of doing business or extending credit, but understanding the tax implications can help mitigate \ufb01nancial losses. When a bad debt becomes partially worthless, the ability to claim a deduction can provide relief for taxpayers. However, navigating the rules under Section 166 requires careful attention to detail, proper documentation, and an ability to clearly demonstrate worthlessness. Businesses and individuals alike should be proactive in taking steps to monitor their receivables, document collection e\ufb00orts, and consult tax professionals when necessary. By doing so, they can ensure compliance with tax rules and maximize allowable deductions. Ultimately, a well-informed approach to bad debts can turn a challenging situation into an opportunity for better \ufb01nancial management and tax e\ufb03ciency.<\/p>\n

_____________________<\/p>\n

1<\/sup><\/em> Treas.<\/em> Reg.<\/em> Section<\/em> 1.166-1(c).<\/em><\/p>\n

2<\/sup><\/em> Generally, bad debts of a corporation <\/em>(other<\/em> than<\/em> an<\/em> S<\/em> corp)<\/em> are<\/em> always<\/em> treated<\/em> as<\/em> business bad debts. See Section 166(d)(1).<\/em><\/p>\n

3<\/sup><\/em> Section<\/em> 165<\/em> generally<\/em> pertains<\/em> to<\/em> certain<\/em> losses with speci\ufb01c limitations, including casualty losses, theft, and worthless securities.<\/em><\/p>\n

4<\/sup><\/em> Section<\/em> 166(a)(2) and Treas. Reg. Sec- tion 1.166-3(a)(2). Generally, all taxpayers, except for certain \ufb01nancial institutions, must use this speci\ufb01c charge-o\ufb00 method. How- ever, certain service-based accrual method businesses may be able to use the nonaccrual experience method under Section 448(d)(5).<\/em><\/p>\n\n <\/div>\n<\/div><\/div>","protected":false},"template":"","meta":{"_acf_changed":true},"class_list":["post-2814","insight","type-insight","status-publish","hentry"],"acf":[],"yoast_head":"\nPartial Bad Debts: An Opportunity Hiding in Plain Sight - GTM Tax<\/title>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/gtmtax.com\/insight\/partial-bad-debts-an-opportunity-hiding-in-plain-sight\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Partial Bad Debts: An Opportunity Hiding in Plain Sight - GTM Tax\" \/>\n<meta property=\"og:url\" content=\"https:\/\/gtmtax.com\/insight\/partial-bad-debts-an-opportunity-hiding-in-plain-sight\/\" \/>\n<meta property=\"og:site_name\" content=\"GTM Tax\" \/>\n<meta property=\"article:modified_time\" content=\"2025-10-06T12:58:12+00:00\" \/>\n<meta name=\"twitter:card\" content=\"summary_large_image\" \/>\n<script type=\"application\/ld+json\" class=\"yoast-schema-graph\">{\"@context\":\"https:\/\/schema.org\",\"@graph\":[{\"@type\":\"WebPage\",\"@id\":\"https:\/\/gtmtax.com\/insight\/partial-bad-debts-an-opportunity-hiding-in-plain-sight\/\",\"url\":\"https:\/\/gtmtax.com\/insight\/partial-bad-debts-an-opportunity-hiding-in-plain-sight\/\",\"name\":\"Partial Bad Debts: An Opportunity Hiding in Plain Sight - 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